A company generally does not distribute all its earnings amongst the shareholders as dividends. A portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or self financing or ‘ploughing back of profits’.

The profit available for ploughing back in an organization depends on many factors like net profits, dividend policy and age of the organization.

Advantages

The advantages of retained earnings as a source of finance are as follows:

Retained earnings is a permanent source of funds available to an organization;

It does not involve any explicit cost in the form of interest, dividend or floatation cost;

As the funds are generated internally, there is a greater degree of operational freedom and flexibility;

It enhances the capacity of the business to absorb unexpected losses;

It may lead to increase in the market price of the equity shares of a company.

Disadvantages

Retained earnings as a source of funds has the following limitations:

Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends;

It is an uncertain source of funds as the profits of business are fluctuating;

The opportunity cost associated with these funds is not recognized by many firms. This may lead to sub-optimal use of the funds.